Companies can raise capital to finance their business from several sources;
equity capital can be provided by institutions, such as pension funds, and private investors, while debt can be provided by banks, other institutions and private individuals.
A particular company’s cost of capital will be dependent upon the perceived risk as judged by the market. Both the investors buying equity and the banks and others providing debt will require a higher return if they perceive that the company they are being asked to supply capital for is considered risky.
However, a company’s cost of equity capital is not the same as the investors’
overall expected return buying into that company. Likewise, the company’s cost of debt capital will not be the same as the expected return of the banks lending the debt. In both cases, the difference will amount to the cost of ‘risk’. Not all of the investors’ investments will meet the expected return and banks will expect that some of their lending will not be recoverable. The only time the cost of capital is equal to investors’ expected return is when risk-free government bonds are purchased.
This concept is the same as the principle of insurance. Insurers assess risk and calculate premiums accordingly. For example, they might charge an eighteen- year old £2400 to cover a particular car fully comprehensive, but charge a 54-year old only £800 for the same level of cover on the same car in the same geographical area. The cost of cover for the two individuals is vastly different, but the insurance company would expect to make the same return on both, the difference being they would forecast that the 18-year old was more likely to make a claim.
A company’s cost of equity capital will be equal to investors’ expected return
Equity – ordinary shares
A private equity provider will expect a compound return ranging from 30%
to invest in management buyouts and established but unquoted businesses to 100% for start-ups. For companies quoted on main stock exchanges, the cost of capital for an individual company is said to be dependent upon its beta, as determined by the capital asset pricing model (CAPM). This model was developed by William F. Sharp and was described in his 1964 paper ‘Capital asset prices: a theory of market equilibrium under condition of risk’,Journal of Finance(September 1964). Mr. Sharp won the Nobel Prize in Economics for his development of the CAPM.
The CAPM states that the expected return from a security is
The risk free rate+ (expected return of the market portfolio− risk free rate)
× beta.
The beta is a calculation of how a particular share would be expected to move in line with the market as a whole. If a particular company’s share price was expected to move in line with the market as a whole, it would have a beta of 1, while if a ±10% movement in the market would result in the share price moving±20%, then the beta would be 2.
So, if we assume that the risk free rate is 4.70% and the expected return on the market portfolio was 14.00%, then the expected return for shares with a beta of 0.8, 1.0 and 1.5, respectively, would be:
470%+1400%−470%×08 = 1214%
470%+1400%−470%×10 = 1400%
470%+1400%−470%×15 = 1865%
The CAPM is calculated using various economic assumptions, some of which can be considered dubious from a practical point of view. These assumptions form the basis of what is known as the ‘efficient market hypothesis’ and include the following:
• Investors are rational, are risk averse and will assess securities on the basis of the expected return and standard deviation or variance of return.
• The market is perfect (shares go on a ‘random walk’) and there are no transaction costs.
• Investors will diversify away unique risk, so only market risk needs to be considered.
In his book Where Genius Failed – The Rise and Fall of Long Term Capital Management(Harper Collins, 2001), Roger Lowenstein describes how belief in the efficient market hypothesis led the managers of a fund with the name ‘Long Term Capital Asset Management’ to lose $3.6 billion. He quotes a senior US official and a US economist:
Lawrence Summers, at the time a US Treasury Secretary, is quoted as saying,
“the efficient market hypothesis is the most remarkable error in the history of economic theory” (p. 74).
Robert J. Schiller, an American economist, agreed and dared to suggest that “mar- kets were too volatile to fit the model of perfect markets” (p. 75).
For some academics, the thought that the efficient market hypothesis is not valid is simply too much to bear. Lowenstein describes ‘how Eugene Fama, Scholes’s thesis adviser, devoted the rest of his career to justifying the efficient market hypothesis’ (p. 74) even though his own research into stock prices suggested otherwise (p. 71).
Many academics do, however, recognise the importance of human behaviour with regard to investment decisions and are trying to develop models that take account of this. However, they are currently outnumbered by the traditionalists, who argue that mixing finance with human behaviour is effectively mixing different disciplines. These academics argue, with valid reasoning, that models developed using invalid assumptions are better than having no model at all.
A model that will give the correct answer 80% of the time must be better than being in the position where everything is unknown. Otherwise, they question:
how can progress be ever made?
Such reasoning is, of course, perfectly sensible as long as it is appreciated that, with regard to projecting the future in respect of making investments in stocks and shares or other forms of gambling in markets buying and selling financial products, mathematical models are fallible. Occasionally they must give the wrong answer, and any investor having absolute faith that they will always give the right answer in the long term, like Long Term Capital Management, will risk losing everything. However, in perfect or near perfect markets, math- ematical models will enable the gambler using such models to have a winning advantage.
the long term where the odds received on bets are greater than the true odds (i.e. the true probability) of an event happening and will lose in the long term where the odds, expressed as a probability, are lower than the true probability of an event happening. The simplest example is the spin of a coin where the probability of heads and tails coming up on any spin is 0.5. If a gambler was offered 6/4 against the chance of a head coming up on the next spin and in every subsequent spin thereafter, then in the long term he would be guaran- teed to win. In this case, if the stake was £10, then the expected value (EV) would be:
EV= (Benefit of winning×probability of winning)− (Cost of losing
×probability of losing)
EV= (£15×0.5) – (£10×0.5)= £7.50− £5.00= £2.50
If there were to be 1000 spins of the coin, the expected winnings would be 1000×£2.50=£2500. This could be represented as:
500 winning bets, winning £15=£7500, less 500 losing bets, losing
£5000=£2500.
Now, the EV simply suggests what is likely to happen, as heads could come up more than 500 times in 1000 spins and, of course, could come up less than 500 times. What is known is that the more times the coin is spun, the greater likelihood that the cumulative result will get closer to the probability.
In any game of cards where the full pack is used, the player who can remember the cards already played and therefore is able to calculate with a fair degree of accuracy the probability of which cards are about to come up will have a distinct advantage of playing against a player not having that ability. This is why some people can make a living playing cards on internet websites, while the majority of players will lose.
An example of a market that is as near to perfect as it is possible to get is the horserace betting market. The form of each horse, the rider and the trainer are known before the start of each race and can be ascertained very quickly by a click of a mouse at the appropriate website. In addition to this, as the market progresses, ‘insider’ knowledge, being up to date information known only to the connections of a particular horse, may become freely available. What can happen is that as horses are backed, their odds contract, while the odds are pushed out for those not being backed. In other words, by the off of the race, the market has reflected what is perceived to be the probability of each horse winning. Now, bookmakers make a profit by offering odds that are slightly
worse than the true probabilities and accordingly, in the long term, they can expect to win.
The cornerstone of modern financial economic theory is that markets are per- fect, but it is a simple matter to prove that imperfections in the market make this supposition unrealistic. For a start, the information available to the mar- ket place is very complex and is open to different interpretations. The notion that at any one time the market has priced in the information available to it about a particular share and that accordingly that share will go on a ‘random walk’, meaning that it is impossible to tell whether it should go up or down, is stretching the imagination. Is it really realistic to imagine that as a piece of information (such as a new set of accounts, or profit warning) hits the mar- ket, ‘the market’ assimilates it in an instant to arrive at a new ‘correct’ market price?
What happens is that as a piece of information comes in, the market will react, but not necessarily in a rational way. Chapter 4 will give actual examples where advantage could have been taken because ‘the market’ reacted to the headlines and had not fully studied the detail. The following example illustrates the point: If interest rates suddenly go up to 2%, the market will panic and downgrade everything, including companies sitting with millions in the bank who would likely benefit. Clearly, in this example, the market would correct the anomaly relatively quickly, nevertheless the quick witted would have had an opportunity.
In a perfect market, all players have identical information at the same time and can act upon it accordingly, but to suggest that this can happen in financial markets is again not realistic. An objective of this book is to show that by analysing published accounts, private investors can gain an advantage against the market as a whole. The reason for this is that in the same way that a small company can be more entrepreneurial than a large conglomerate company, private investors have the advantage of speed over fund managers who are often constrained by rules laid down by their employer.
But the real problem is that the financial information is not clear-cut. Even if it was believed that all investors have the same information available to them and act upon such information in unison, it will be open to interpretation,
risky to another. When accounting for human nature, the wisest view to take with regard to the future is that anything can happen. Even where the market is in general agreement, it is not possible to forecast which event will force it into the panic mode with the effect that investors simply follow the crowd rather than act rationally.
What this means is that neither mathematic models based on economic finan- cial theory nor an analysis of financial accounts can provide guaranteed results, but it is argued that the latter by trying to predict the better companies in the market as a whole has the advantage (if the analysis is correct) of really eliminating specific risk. Diversification does not, as it is said, ‘diversify away specific risk’, rather it ensures that bad companies are mixed with good com- panies to achieve the market mean.
Nevertheless, the CAPM illustrates, correctly, that the expected return will increase as the perceived risks increases. However the ‘expected return’ should not be confused with the ‘overall expected return’. It must be remembered that the return an investor can expect is the ‘overall expected return’ and NOT the
‘expected return’.
The ‘overall expected return’=‘Percentage of successful investments× expected return
The following table illustrates:
Percentage of successful investments
Expected return
Overall expected return
Government bonds 100 4.7 4.7
Quoted companies Unquoted investments
(private equity)
96 80
14.0 40.0
9.4 12.0
Now, even the ‘overall expected return’ will not be accurate in the sense that actual is very unlikely to equal budget or forecast. Certainly, it is unlikely that for any given security, the expected return as calculated by the CAPM will equal the actual.
The CAPM is dependent upon the accuracy of the beta calculation for each stock, but how accurate this can be is debatable. The beta for each share
is calculated by comparing its stock price with the market average over a significant length of time, but how much a share has moved because of the market and how much it has moved due to unique events within the company seem difficult to deduce. If it is assumed that the beta has to be correct and that any difference in total movement in a share price and that calculated due to the market is movement due to ‘unique events’, then the CAPM is a self-fulfilling prophesy.
For example (see Chapter 4 – The Experiment), Chaucer Holdings plc was selected as one of the four companies to be backed against a portfolio of 16 companies. On December 2006, this company’s beta was quoted as 0.33, so (given the expected return of the market portfolio for FTSE Smallcap stocks is 17.5%) the expected return would be: 47%+ 175%− 47%×033=892%.
The share started at 60 pence in 2006 and ended the year at 100 pence, and assuming dividends cover transaction costs, the actual return for the year was 66.67%. Of course, it could have gone the other way, the point being that when one is trying to predict the future, any formula you use requires a sprinkling of judgement.
Ordinary shares (new issues) are usually sold by companies at a different price than that shown on the share certificate. The price shown on the share certificate will be the ‘par value’ and the difference between this price and the actual selling price will be credited to the ‘share premium account’. In the EIS example, with regard to the shares sold to the public, 0.1 pence would go to
‘share capital’ and 1.4 pence would go to ‘share premium’. The cost of a share issue is usually debited to the share premium account.
Say, for example, a company issues 1 million ordinary shares of 10 pence for 75 pence and the cost of issuing the shares is £45 000, then the entries would be:
Debit ‘cash received’ £705 000 (£750 000 less £45 000) Credit ‘share capital’ £100 000 (1 million shares at 10 pence)
Credit ‘share premium’ £605.000 (1 million shares at 65 pence = £650 000 less £45 000).
Preference shares
Preference shares are simply shares that take preference over ordinary shares.
Preference shares are issued with a fixed coupon. For example, a company issuing 8% £1 preference shares would pay a dividend of 8 pence on every share each year, provided the company made sufficient profit to do so. If the company had to pass this dividend (not pay it), then the directors of the company would not be allowed to pay any dividend on the ordinary shares. No dividend can be declared on ordinary shares until the preference shareholders have been paid.
Likewise, if the company had to be wound up, ordinary shareholders would not be entitled to receive a penny until the preference shareholders had been paid in full.
Cumulative preference shares
A company might have had a bad year and have been unable to pay the div- idend due on its preference shares, and then follows a brilliant year allowing it to pay not only the preference dividend but also a bumper dividend on the ordinary shares. Not surprisingly, under such circumstances, preference shareholders are likely to feel miffed; so to avoid such a scenario, companies issue cumulative preference shares. This means that the preference sharehold- ers must receive ALL the dividends due to them before ordinary shareholders could be paid. So, if a shareholder holding 6% £1 cumulative preference shares had not received a dividend for 2 years, in the third year he would have to receive a dividend of 18 pence per share, before an ordinary dividend could be declared.
Preference shares can also be varied to carry various entitlements or conditions:
9% Cumulative Redeemable Convertible preference shares:
• Shares are preference shares that carry a 9% fixed dividend.
• If the dividend is not paid in any year, the shareholder is entitled to be paid a double dividend in the following year, etc.
• Subject to the conditions set down at the time of issue, the company can redeem (buyback) the shares.
• The company can convert the preference shares into ordinary shares or debt, as determined by the conditions set at the time of the issue.
Debentures
Debentures are loan notes issued by companies that are secured against the assets of the business, usually in the form of a fixed and floating charge over all the assets. A debenture will usually be issued for a fixed term, with a coupon showing the fixed interest rate per annum. The interest rate payable will usually be a few percentage points over the base rates.
Bonds
Bonds are loan notes that are unsecured. In other words, the bond holder would be an ordinary creditor, rather than a preferential creditor if the company were wound up. Where companies have a good credit rating, the bonds are deemed to be investment-rated bonds, whereas companies have a poor credit rating, the bonds are known as junk bonds. Investment-rated bonds will pay interest at an annual percentage rate in single figures, while to attract investors to take risks, the annual interest rate for junk bonds will often be in double figures.
Loans
Debentures and bonds will be issued to individuals, whereas loans usually refer to money lent by banks. Banks will usually lend money this way if they are preference creditors by having a fixed and floating charge against the company’s assets. The interest rate charged will vary from one-quarter of 1%
above the bank base rate for large blue chip companies to four percentage points above the risk-free rate for smaller, riskier companies; so if the risk-free rate were 5%, a small company might have to pay 9% per annum for a loan.
The objective for the owners of such businesses is to persuade the bank that they are not that risky as to be placed in this high-risk category. The loans are usually repaid over a fixed period in instalments, with instalments due every quarter, half-year or year, as determined by the agreement.
Bank overdraft
Hire purchase
Companies that cannot offer sufficient security to be given a loan, or are deemed to be too risky for the banks to take on, often have to resort to hire purchase to acquire new assets. In this case, the lender having paid for the asset will be its legal owner and will ‘hire’ it to the company. There will be a clause in the agreement that when the company has repaid the principal in full, together with the cumulative interest, the company can purchase the asset for a nominal (very small) amount. The interest rate charged under hire purchase agreements is usually much higher than that charged for loans.
Debtor discounting/factoring
For companies unable to secure a bank overdraft and therefore unable to fund working capital, an alternative form of funding is debtor discounting or fac- toring. This is a very expensive option in that the lender buys the company’s debtors at a heavily discounted rate. The discount demanded will take into account a very high interest rate, together with an amount to insure against bad debts. Companies can negotiate a slightly lower rate of discount if they take on bad debts themselves. Under such arrangements, the lender will pay the company for the invoice as it is issued, but will then demand repayment, plus interest, if they are unable to recover the money from the company’s debtor after a set period of time.